“Target Zones and Forward Rates in a Model with Repeated Realignments”

The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.

Abstract

The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.

This paper examines the implications of the imperfect credibility of an exchange rate target zone for the term structure of forward premia. The relationship between spot and forward exchange rates of different maturities is developed in a model of exchange rate target zones with possible realignments. The term structure of forward rates is obtained as a function of the intervention rules and the realignment probabilities describing the credibility of the target zone.

Various sets of intervention rules at different levels of credibility are discussed. Standard target zone models are consistent with a wide variety of relationships between forward premia and spot exchange rates when allowance is made for imperfect credibility of the band. When the credibility of the target zone is low, for instance, the forward premium is a broadly increasing function of the position of the exchange rate in the band; a bimodal pattern arises when the devaluation probability at the upper boundary of the band differs from the revaluation probability at the lower boundary, a likely characterization of real-world target zones.

The credibility of the target zone implicit in forward market data can be calculated by estimating the model. Application of the model to French and German data since the start of the EMS indicates that the model is capable of matching observed patterns of interest rate differentials while yielding estimates of the credibility parameters that accord with the experience of the FF/DM exchange rate during the 1980s, including a significant increase in the credibility of the FF/DM target zone from the end of 1986. Tests of the hypotheses of full credibility of the target zone and of linearity of the relationship between the spot exchange rate and exchange rate fundamentals point to the empirical relevance of realignment risk and the potential gains from estimating target zone models from forward market data.

Working Paper Summaries (WP/92/1 - WP/92/47)
Author: International Monetary Fund